Facts
Name / Symbol / Code Euro / € / EUR
Popularity
Ranking
 2 / 165
 Used in  Eurozone (17)
Outside of EU (7)
Unofficially: 5 Others
 Pegged by  10 Currencies
Central Bank European Central Bank (ECB)
www.ecb.europa.eu
 Interest Rate 0.75% (July, 2012)
Inflation Rate 2.40% (July,2012)
Method: Harmonized Index of Consumer Prices (HICP)
Coins
1c 2c 5c 10c 20c 50c €1 €2
               
Banknotes
€5 €10 €20 € 50
       
€100 €200 €500
     
 Printer Several
 Mint Several
Major Pair EUR/USD
Key
Crosses
 EUR/JPY  EUR/CAD
 EUR/GBP  EUR/AUD
 EUR/CHF  EUR/NZD
Most Active
Trading Hours
 European Open  7:00PM ET / 23:00 GMT
 EUR Economic Releases  7:30PM ET / 23:30 GMT
 USD Economic Releases  8:30AM ET/ 12:30 GMT
Correlated Class Popular European Stock Indexes
* EUROSTOXX 50 * CAC40 * DAX * IBEX 35

The official currency of European Union, the Euro (sign:€; code: EUR) is the second most actively traded currency after the US Dollar, accounting for 31.1% of the daily trading. EURUSD is the most active pair, accounting for 28 percent of the daily global trade volume, according to the 2010 BIS survey. The euro’s foreign appeal comprises two factors: 1) it ties the US as the world’s largest economic block; and 2) because of its massive economic size, the Euro has become attractive as a reserve currency, with foreign governments and central banks increasing their reserve holding in Euros because of its perceived strength against the US Dollar.

Rank Currency Code
(Symbol)
%Daily
Share
1 US Dollar USD ($) 84.9%
2 Euro EUR (€) 31.1%
3 Japanese Yen JPY (¥) 19.0%
4 Pound Sterling GBP (£) 12.9%
5 Australian Dollar AUD ($) 7.6%
6 Swiss Franc CHF (Fr) 6.4%

Currency Reserve Status: Steadily growing since its inception. Reserves in US Dollar had shrunk from 71% to 62% from 1999-2012, while reserves in Euro had increased from 17.9% to 24% over the same period. Some of argued that the Euro might replace the Dollar as the world’s reserve currency in 2020, but the European Sovereign Debt Crisis has shaken much confidence in this projection. See global currency reserve table.

Moreover, the Eurozone holds large foreign currency reserves of $932 billion (third after China’s $3.3 trillion and Japan’s $1.27 trillion), which boosts the value of the Euro. List of countries by foreign exchange reserves: here.

In most broad currency baskets, EUR has a high weighting.

Basket Index / Currency Weighting
USD Dollar Index EUR (57.6%),JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), CHF (3.6%)
IMF Special Drawing Rights (SDR) USD (41.9%), EUR (37.4%), GBP (11.3%), JPY (9.4%)

In terms of pair popularity, EUR/USD is the most active pair, accounting for 28% of the daily global trade volume, according to the 2010 BIS survey.

The popularity of this pair makes it highly liquid, which creates very narrow spreads – typically 2 pips or less, versus 3-5 pips in other major pairs.

Central Bank: European Central Bank (ECB)

Headquarters Frankfurt, Germany
Created  1 June 1998
Mandate Maintain Price and Financial System Stability
President Mario Draghi
Website www.ecb.europa.eu

The nations of the Eurozone delegated monetary policy (setting interest rates) to the newly founded European Central Bank (ECB) and the Europen System of Central Banks (ESCB) which comprise the ECB. The European Central Bank (ECB), acting independently from governments, has monetary control and a “one-size-fits-all” interest rate policy among the Euro members, despite surpreme mismatches in political and economic structure between member states. In the wake of banking and sovereign debt crisis, the ECB has lowered interest to near zero and provided weaker banks (mostly from crisis countries) with cheap loans of more than one trillion Euros. Maastricht and Lisbon treaties (example: Article 123) had forbidden the European Central Bank to lend money to governments directly, but it has done so indirectly via the lending to a government guaranteed entity (the bank), who in turn lends to the government. Recently, as of September 2012, the ECB has become more aggressive in its willingness to purchase unlimited amounts of government bonds facing high bond rates in a program called Outright Monetary Transactions (OMT), provided that the countries first seek assistance from the bloc’s rescue funds and agree to international oversight of their fiscal and economic policies. German critics say that by agreeing to purchase government bonds the central bank has overstepped its anti-inflation mandate. Rising inflation will pose an obstacle to how much the ECB will engage in money printing, given that its target is below 2%.

Economy

  • The Euro Area is the second largest regional economy after the US. It represents approximately 17 countries and 333 million people with a total GDP of 13 trillion dollars, with a per capita GDP (PPP) of $34,100 (2011,est). These countries have retired their own national currencies and adopted the euro as their single currency.
  • There are supreme mismatches in political and economic structure between member states, and today, after the European Sovereign Debt Crisis, it can be readily seen that the Eurozone can be divided into two economic blocks, the Center and the Periphery.
  • The center (also called “northern core” or “creditor states”) consists first and foremost of Germany, the leading producer and exporter of high-value-added products. It has the largest current account surplus, GDP, population, and enjoys a healthy financial system (low unemployment, low bond yields, low private and public debt). The German Central Bank, the Deutsche Bundesbank, is one of the strongest members of the European Central Bank (ECB), and it enjoys a legendary reputation for controlling inflation through the second half of the 20th century, making the German Mark the most respected currency before it was retired. Germany’s neighbors, Netherlands and Austria, also have sizable current account surpluses, GDP, and healthy public and private financing. All three nations have performed extraordinarily well, even in the face of the global recession. France has a great economic output, even if it does not have nearly as great a trade balance and budget balance as Germany, and so it is considered part of the center, at least for now.
  • The periphery (also called “southern tier”, “club med”, “debtor states”, or the loaded acronym “PIIGs”) consist of Portugal, Ireland, Italy, Greece, and Spain, countries that been mired in terrible trade and budget deficits since 2009. They flourished well under the credit bubble expansion from 2000 to 2008 as they took advantage of low interest rates inherited from stronger EU nations to borrow and consume beyond their means, but when asset prices became too high relative to incomes, the private sector could borrow no more and the housing bubble burst, devastating the household and financial sectors. The national governments entered typical Keynesian mode and jumped up spending to “alleviate” the crisis (with Ireland and later Spain nationalizing its troubled banks) at the same time revenues diminished because of the recession, until the government too became its victims, reaching an endpoint where now their budget deficits are significantly larger than their nation’s current account deficits, resulting in higher government bond yields and overly stretched banks (the Sovereign Debt Crisis).
  • Under their own currency regimes, the periphery states would no doubt attempt a second Keynsian maneuver of printing money to monetize their debt with resulting inflation, which in turn creates financial instability (and crushes savers), yet temporarily alleviates trade and budget deficits by making exports and debts cheaper. While the European Central Bank was forbidden to print money to buy government bonds directly, it did in fact print and lend billions of Euros to periphery banks at low interest rates, and these banks in turn purchased bonds of their troubled governments. However, when bonds were reduced to junk status because of the increased risk of government default, the banks were also put in jeopardy of bankrupsy (holding too much toxic mortgages and bonds), and so the ECB began actively printing and purchasing the bank’s toxic assets in order to save them.
  • Currently, the periphery governments (and the banks who have loaned money to them) have been put on a life support system of bailouts in order to avoid default or bankrupsy. Two bailout entities have been slowly mobilized to the rescue: the European Central Bank to bailout the beleaguered banks (and now the governments) and European Agencies (EFSF/EFSM/IMF/EMA) to bailout the beleaguered governments.
  • The EU created the temporary European Financial Stability Facility (EFSF), a special purpose vehicle financed by members of the EU to the tune of 780 billion Euros ($1 trillion) to provide financial assistance to eurozone states in economic difficulty (Irish Bailout: 85 billion; Portuguese Bailout: 78 billion; Greek Bailout: 164 billion). It will later be replaced by a more permanent European Stability Mechanism (ESM), which will be expected to authorize capital of 700 billion euros of which 80 billion is paid-in-capital, and the remaining 620 billion -if needed- will be lended through the issuance of some special ESM obligations at the capital markets. All these bailouts are provided in return for promised austerity measures, such as structural reforms and reductions in the public debt and deficits. “Growth through structural reforms is sensible, important and necessary,” German Chancellor Angela Merkel told parliament in Berlin. “Growth on credit would just push us right back to the beginning of the crisis, and that is why we should not and will not do it.”
  • Both the center and periphery feel frustrated and resentful with the current situation: the periphery feel resentful against the austerity measures (cuts on wages, social spending, welfare, social services, public sector jobs, and tax increases) aimed at getting the “fiscal house in order,” and the seemingly endless fall into poverty, unemployment, and misery;  the center (particularly Germany) feel resentful at having to continuously bail out nations that cannot get their financial house in order, and fear that the provisions in the EFSF and ESM, as well as the sheer amount of money involved in these funds, will lead to a significant redistribution of revenues from creditor states to debtor states, at least until the loans are repaid.
  • With the “unlimited intervention” of the ECB and EFSF/ESM to provide indefinite life support to the periphery, on condition of structural reform, the immediate future seems less like the break up of the euro and more like an indefinite extension of the crisis. A disorderly breakup would be catastrophic for the euro area and indirectly for the whole world. The EU that will likely emerge (at least for the time being) will be hierarchical (two-tier) system built on debt obligations, with two classes of states, creditors and debtors, with the creditors in charge and Germany the leader (despite Germany having no imperial ambitions). Debtor countries will have to submit to European supervision and austerity measures, which will mean depression and hardship till structural reforms help them become more competitive again.
  • Euro Area’s labor force consisted of about X million workers with a unemployment rate of around 11.34% (Q2/2012), with Spain having the largest at 24.3%. Youth employment is above 50% in Spain and Greece.

Many of the above points can be quickly visualized by glancing at the table of the major economic indicators of all 17 nations in the Eurozone:

State Enter Pop
(mil)
GDP
(billion USD)
Relative GDP Real Growth
(2011)
Job
less
Current
Account
(2011)
S:World
Bank
Debt to GDP
(2011)
S:IMF
Gov.
Bud
Bond
Yield
(08/12)
Germany 1999 81.75 3570 28.80% 3.1  6.0 5.67 81.5  -1.0  1.34
 France 1999 65.07 2650 21.38% 1.7  9.7 -1.96 86.3  -5.2  2.12
 Italy 1999 60.62 2112 17.04% 0.4  8.4 -3.27 120.1  -3.9  5.82
 Spain 1999 47.19 1460 11.78% 0.7  21.6 -3.48 68.5  -8.5  6.68
 Netherlands 1999 16.65 792 6.39% 1.3  4.5 8.44 66.2  -4.7  1.76
Belgium 1999 10.91 468 3.78% 1.9  7.2 -0.94 98.5  -3.7  2.54
 Austria 1999 8.40 384 3.10% 3.1  4.2 1.90 22.9  -2.6  1.97
 Greece 2001 11.32 33 0.27% -6.9  17.3 -9.78 160.8  -9.1  24.34
 Finland 1999 5.37 237 1.91% 2.9  7.8 -0.69 48.6  0.5  1.55
 Portugal 1999 10.63 227 1.83% -1.5  12.7 -6.49 106.8  -4.2  9.89
 Ireland 1999 4.48 227 1.83% 0.7  14.4 0.06 105  -3.1  5.91
 Slovakia 2009 5.43 87 0.70% 3.3  13.4 0.01 44.6  -4.8  4.24
 Luxembourg 1999 0.51 52 0.42% 1.0  6.0 7.03 47.3  -0.6  1.66
 Slovenia 2007 2.05 48 0.39% -0.2  8.1 0.00 20.8  -6.4  6.81
 Cyprus 2008 0.80 24 0.19% 0.5  7.8 -10.3 71.8  -6.3  7.0
 Estonia 2011 1.34 19 0.15% 7.6  12.5 2.15 6  1.0
 Malta 2008 0.41 7.4 0.06% 2.1  6.4 -1.31 70.9  -2.7  4.04

What columns to pay attention to? All columns are interesting, but as a currency trader, the three most interesting at this time are GDP growth, current account and budget balance.

GDP growth matters the most when it is tied up with a current account surplus, for then we know for sure that the growth came from a competitive export advantage and not just from credit-fueled consumption that we now know ends in burst asset bubbles. The short list of countries with decent growth and current account surpluses are, in order of economic size, Germany, Netherlands, Austria and Estonia. Germany has become the economic superstar with unemployment at 20-year lows and exports at an all-time high, producing 30% of the Eurozone’s GDP. Germans are practically euphoric these days, and this optimism is joyriding the powerful export machine, seemingly impervious to the nightmare besetting the periphery. Most did not go crazy with speculative housing mania (and resulting bubbles) that gripped the US, UK, Ireland, and Spain. The German housing market stagnated after reunification, and when adjusted for inflation declined for many years, which in hindsight is a good thing, for it leaves them unscathed during the global recession. This northern core has managable government deficits and low yield governments bonds that  that can be easily financed without going into deficit spending. However, as the global recession moves into its fifth year, look for the potential of German exporters to get hit from two sides: continued trouble in the Eurozone and slowing demand in China. The economic strength of Europe lies with its core nations, particularly Germany, and if Germany falters and stumbles, then the Eurozone GDP growth and current account will stumble as well.

GDP growth yoked to current account deficits is more related to credit fueled consumer spending, and in today’s burst asset bubbles and overly indebted borrowers, we know that countries with this dynamic are bound to suffer severe economic contractions and higher unemployment. The long list of countries with tepid or negative growth and current account deficits are, in order of economic size, France, Italy, Spain, Greece, Portugal. Interestingly enough, Ireland used to be in current account deficit prior to 2010 as it was heavily reliant on its housing bubble for economic growth, but it has edging into current account surplus in recent years no doubt in part because of its low 10% corporate tax rate attracting powerful corporations like Intel and Google to its shores. Without trade surpluses, these debtor states become reliant on domestic and foreign credit to fuel their private and public debt consumption. For a good ten years this had seemed to work for them; they had managed to borrow and live well beyond their means, but now the asset bubbles have burst somewhat (they have room to decline further), and borrowers are maxed out. The question is: will the credit bubble be allowed to fully deflate with prices and wages falling to a point where recovery can begin again on more competitive terms (as the Germans would hope), or will the Keynsians of Europe manage to print and pump addition debt to prop up the bubble and/or create new ones in its wake? Given that ECB interest rates are now at near zero (in order to fuel more debt) and it has committed itself to the purchase of unlimited government bonds, one can safely conclude that the Keynsians are currently in control, which ultimately means that debt fueled inflation is seen as a cure for the economy, a phenomena that puts downward pressure on the Euro.

Bailouts to the troubled periphery will be an ongoing inflationary drag on the Euro. Keep in mind that bailouts are now coming from two quarters: the EU Bailout Agencies (EFSF/ESM) are raising $1 trillion in capital guaranteed loans to lend to the troubled states, and European Central Bank, which once forbidden to lend money directly to governments, is now prepared to purchase unlimited amounts of government bonds facing high bond rates in a program called Outright Monetary Transactions (OMT), provided that the countries first seek assistance from the bloc’s rescue funds and agree to international oversight of their fiscal and economic policies. Insofar as both methods involve the creation of new debt money, they are both inflationary, meaning that they will both put downward pressure on the Euro to the degree they are used. True, it can be argued that the ECB version is more inflationary, given that it will be outright printing money to buy bonds, whereas the EU Bailout Agencies will be raising money from investors and leveraging that money via the fractional reserve system (the leverage part leads to inflation). Currency traders should track the extent and degree each is used. The bailout agencies will publish how much government debt they are buying. The ECB will likewise publish how much bank and government debt it is buying. As for anticipating how much the ECB will end up buying in the future, that will be trickier given that it will share government bond buying with the EU Bailout Agencies. It will be hard to measure the degree of bond buying that the ECB will be engaged in going forward, given conditional forces at work. Conditional forces: the Rescue fund (ESM) assistance is given priority over ECB assistance, the recipient debtor nations must agree to the assistance and the fiscal/economic oversight, which they might be reluctant to do at times given the austerity strings attached, and the creditor nations must also agree to the assistance at each stage, which they might be reluctant to do at times given their anti-inflation mandate of less than 2% (Central bank money printing to buy bonds raises inflation). These conditional forces also mean that, though the Eurozone as allowed an unlimited printing (and bailout) engine to operate, it will not be as fast and orderly as the printing engines of the US and UK. Long term upshot: expect less monetary inflation and thus less Euro depreciation relative to the more aggressive printing engines behind the US Dollar and Pound.

Here is a table of EU in the big picture of things, next to all its major competitors (Updated as of July, 2012):

Country GDP
(Billion USD)
GDP
(YoY)
Interest
Rate
Inflation
Rate
Jobless
Rate
Gov.
Budget
Debt
to GDP
Current
Account
Pop
United States 15094 2.20% 0.25% 1.70% 8.30% -8.70 103 -3.10 311.59
Euro Area 13076 -0.10% 0.75% 2.40% 11.20% -4.10 87.20 -0.40 332.99
China 7298 7.60% 6.0% 1.8% 4.10% -1.10 25.8 4.0 1344.13
Japan 5867 3.50% 0.0% -0.20% 4.30% -9.70 211.70 2.0 127.82
UK 2432 -0.80% 0.5% 2.4% 8.10% -8.30 85.70 -1.90 62.64
Canada 1736 1.80% 1.00% 1.50% 7.30% -1.50 85.00 -2.80 34.48
Australia 1372 4.30% 3.50% 1.20% 5.20% -4.10 22.90 -2.20 22.62
Switzerland 636 2.00% 0.0% -0.70% 2.70% 0.4 48.60 14.00 7.91
New Zealand 142 2.40% 2.50% 1.00% 6.80% -8.4 37.00 -4.30 4.40

 

Historical Exchange Rate Trends

2004-2008

From 2004 to 2008, the Euro had been trading stronger against most of its major pairings –USD, JPY, CHF, GBP– and only slightly weaker against AUD and CAD.


Source: http://www.google.com/finance

In the four years prior to 2008, most currencies were trading stronger than the US Dollar, and the Euro was no exception, gaining 32% against the US Dollar. The chronic negative current account, and overlarge total debt burden of the US Economy was pushing down the dollar. The Euro was seen as the sexy new currency, the promising new rival to the previous hegemonic dominance of the US Dollar. When the credit bubble was expanding everywhere in the world, the European economy looked as if it was exploding in growth. The euro beat the yen because most traders had piled knee deep into the yen carry trade (borrowing yen at near zero interest to invest in the assets of other currencies) in order to lever up and speculate on the housing / commodity / currencies booms (bubbles) heavily underway during this time. It also appreciated against the “swissie carry trade”: from 2003 to 2007, investors borrowed low interest CHF as a “carry trade” to invest in higher yielding assets (mortgage and private lending in central and Eastern Europe) denominated in other currencies, and this had a dampening effect on the currency appreciation. Because of the concurrent commodity boom, traders saw the commodity currencies of AUD and CAD as more attractive during this time, and thus the reason for their slight appreciation against the euro.

2008-2012

From 2008 to 2012, the Euro been trending weaker against most of its major pairings –USD, EUR, CHF, CAD, AUD–except for GBP, where it was trading stronger against, as you can see from the chart below:


Source: http://www.google.com/finance

The sovereign debt and banking crisis in Europe had caused the Euro to fall up to 37% against the Yen, 26% against the Swiss Franc and Aussie Dollar, and 13% against US Dollar and Canadian Dollar. The only currency it did gain against was Pound, which signifies that no matter how much much attention Euro received over most of this period, the UK must have been in even worst shape. While I cannot predict the future, I do think that the Euro may have fallen too far against the Yen. Whenever risk tolerance moves back into the markets, go long EURJPY for greater upside potential.

Factors Driving the Value of the Euro

Indicator Trend Stats Graph Relative to Majors
Real GDP Growth Rate From 2000-2012,
Avg: 1.6%
2012: 0.0%
2-Yr Trend: Flat
(IMF projects 2% growth rate over next 3 years, very optimistic)

Source: IMF
Current Account
(as % of GDP)
From 2000-2012,
Avg: -0.14%
2011: 0.1%
2 Yr Trend: Flat
(IMF projects 0.3-0.8 for next 3 years, very optimistic)

Source: IMF
Interest Rates From 1998-2012,
Avg: 2.7%.
2012: 0.75%
2 Yr Trend:
Under 1%;
(Crisis level lows, will be subject to possible increase when inflation trends above 2%)

            Source: Trading Economics
Gov Debt-GDP Ratio Mid-Level for Developed Regions:
2011, 82% of GDP
-Less than:
Japan (229%),
US (103%),
UK (83%) and Canada (85%),
More than:
Swiss (48%), &
Australia (22%)
– Debt issues lie within the Periphery.

Source: IMF
Central Bank
Intervention
Cautiously Interventionist
* post 2008, near zero interest rates
* Assets have expanded in favor of ‘Loans to Monetary Financial Institutions’ (MFI) (red) in recent years, the quality of which has deteriorated significantly. However, debasement works somewhat belatedly compared to the US and the UK.

Asset Boom-Bust
Cycle (Housing & Stocks)
Housing
(From 75-08, real terms, – inflation): Ireland: 450%
Spain: 350%
France: 250%
Netherlands: 250%
Italy: 200%
Germany: -10% (exception)
Stocks: 101% gain from 2002 to 2008 (Bubble), watch for reflation

Housing Index
Source: Economist

Stock Index
Source: Google

 

Real GDP Growth Rate

In the best years of the Eurozone, from 2000 to 2007, real GDP growth rate, that is GDP growth accounting for inflation, was 2.5% on average, 1% below that of the US during the same period. Unfortunately for the US, and likewise for the Eurozone ex-Germany, much of that growth was credit-fueled artificial growth. In the US, GDP growth was fueled by 13% annualized growth in home prices; likewise, much of Europe’s growth was fueled by double digit yearly home price increases. The ECB’s expansionary monetary policy (of M3 money growth exceeding real growth by 5%, and real interest rates negative) created run-away asset inflation and an unprecedented speculative bubble. All over Europe except for Germany home prices increased faster than that of the US, which was fast enough. Much of the wealth and jobs generated from these asset bubbles have since been destroyed after they popped, and the bubble crash has still a long way to go.
Note: Monetary pumping and deficit spending can create the illusion of economic growth .It does this by misdirecting more capital into malinvestments – malinvestments which then masquerade as ‘economic growth’ in the official statistics, even while they in reality consume capital and weaken the economy structurally.

It will be interesting to see if Europe can keep its real GDP above water and how much of that growth will be fueled by necessary productivity and structural changes, and how much will be fueled by artificial stimulants (such as low interest rates, printed money, and deficit spending) in a fruitless attempt to sustain or reflate multibubbles (home, stock, private debt, financial debt, government debt) that are bound to eventually fall.

Current Account

Trade balances are the most important fundamental factor determining the long-term direction of exchange rate movements. A country with a trade surplus will normally experience an appreciating currency, while the currency of a trade deficit country will tend to depreciate. The appreciation of the D-mark relative to the USD from 1971 to 1995 (USD/D-Mark moved from 3.5 to 1.5) is due in large part to the growing gap between the Germany’s large current account surplus and the United State’s large current account deficit.

As can be seen from the above table, the Eurozone has entered into a flat line (barely above zero) in terms of Real Growth and Current Account Surplus. There is a push-pull effect going on in the Eurozone: the creditor nations (such as Germany and Netherlands) are experiencing real growth of greater than 2%, and current account surplus greater than 5%, which is the muscle pushing Europe’s growth. However, there are many more states which are experiencing less than 1% real growth and current account deficits greater than -3%, and these are pulling Europe down into the mud. The question is: will the economic strength of Germany and Netherlands, which comprise only 36% of the total GDP, be enough to push the remainder of Europe out of its economic slump (with some in the throws of depression) and into the sunny projections of the IMF for the next three years (IMF projects EU real growth of 2% for 2013-15, conjoined with a current account surplus of 0.5%)?  It is doubtful. On the upside, even if the bailouts and haircuts manage to stop the free fall of the debtor states into full on depression (which is questionable),  there is just not enough real growth in productivity and trade to justify the euro reaching its prior heyday levels of 2004-2008, priced in EURUSD between 1.4 and 1.6.

Interest and Inflation Rates

Interest rates and the differentials between currencies, moves currencies dramatically in the short term, but since there seems to be a coordinated effort between the global central banks to keep interest rates below 1% to spur growth (in borrowing and spending) to deal with the global credit crisis, upward interest rate changes are not expected any time soon. They cannot go much further down, as they are already near zero, and they cannot go up much so long as GDP real growth is less than 2% (it is less than 1% currently) and unemployment is greater than 6% (it is greater than 11% currently). However, bear in mind that Germany (particularly the Budensbank) still carries alot of weight in the European Central Bank, and they are very fearful of inflation trending above 2%. Thus, if you see inflation trending above 2%, which it may very well do because of all the money printing in Europe to deal with the crisis, you might see the ECB under German prodding to increase interest rates to bring the level of inflation back down. Interest rate increases will drive the Euro up in the short term.

Growth is supposed to take into account inflation — at least the effects of inflation, which is the consumer price index. Measuring inflation through its effect on consumer price is problematic, because inflation can be masked, underreported, or flowed into assets. Masked inflation occurs when a productive economy can cause business costs to fall and globalization of the labor market can bring in cheap goods from low labor cost countries. Underreported inflation is when government inflation statistics adopt new account procedures for calculating a “lower” inflation rate. Asset inflation is when the newly printed money flows not at first into consumer goods but into stocks, as did in the 1990s, or into homes, as did in the 1990s and 2000s. Masked inflation, underreported inflation and asset inflation work together to create a bubble: seemingly moderate consumer price inflation keeps interest rates down, making it easier to borrow greater and greater sums of money to invest in assets such as stocks or real estate. One could have easily anticipated the European crisis by looking at the housing market explode in price throughout the periphery, along with the stock market. These were asset bubbles in search for a pin. Whenever asset prices grow a multiple faster than income, it is a bubble.

Government Debt (Debt to GDP & Gov Budget to GDP)

As a whole, Eurozone does not have a big debt to GDP as compared to other nations (82% is less than Japan, US, UK and Canada). However, because it comprises 17 unequal nations, there are many nations, particularly Greece, Italy, Portugal, and Ireland, which are deeply in debt, in terms of Debt to GDP (160, 120, 106, 105 respectively). Budget deficits of these indebted nations are heavily in the red, and cannot be paid by foreigners. In adopting the single currency, the nations agreed to abide by fiscal and policy constraints that limited the ratio of national budget deficits to 3% of GDP, but now 12 of the 17 states are well beyond that threshold. Confidence has seriously eroded in the ability of these governments to continually be able to roll over their debts at affordable rates. The triggering event occurred when Greece announced that its deficits were and had been much larger in recent years than the official statistics had indicated, which raised the once unthinkable thought of default into a strong reality, and began to affect credit costs, which in turn increased doubts about the country’s solvency and the euro monetary system’s survivability.

Interestingly enough, Household debt increased from 52% to 70% of GDP from 2000 to 2007, and financial institutions increased their debt from less than 200% of GDP to more than 250%. A similar pattern was being played out in the US and UK. The explosion of the government debt after 2007 was the result of a necessity to save the private sector, in particular the financial sector. Just like the US, the European governments like Spain and Ireland felt they needed to bail out, or buyback the toxic assets of the financial sector, and thus the taxpayers (via the public debt expansion) ended up absorbing the malinvestments of this sector.

Government debt levels were deemed unsustainable because of their magnitude, as well as because these indebted countries were suffering from ongoing growth and trade problems, which made the debt problems even worse. Bond yields have increased dramatically because of the perceived risk in these indebted countries and still there are shortages of bond buyers to to deal with the growing budget deficits. Just as in the US, private investors could no longer be counted on to purchase all the bonds that European governments would like to issue, and so the ECB had covertly been printing euros to buy them, and thinly disguising the process by funneling it through the banking sector. A bond-buying spree on the part of various country’s banks was caused by the printing of euros by the ECB, loaning them out to banks at the low price of 1% interest for 3 year loans, so that these banks could instantly convert it into their own government bonds yielding a much higher rate. Italian and Spanish 10-year bonds were paying above 5.5%, yielding a 4.5% return for a 1% ECB loan. Ultimately, the Italian banking industry now holds more government debt than the banks of any of the major European economies: nearly €324 billions worth of shaky bonds. The Spanish banking sector is also heavily overweight in government paper, at a new record high of €263 billion, which is in addition to its billions held in toxic real estate assets. Bailout programs with austerity measures have been mobilized to rescue these troubled banks and troubled governments, and the vast sums involved may (or may not be) enough shore up the crisis.

Note: A country with a higher budget deficit to current account deficit needs help of some kind to fund its budget deficit; usually a country with its own Central Bank can fund the shortfall with monetizing the debt (with its Central Bank printing money to loan to the government). Heavily indebted countries like Greece would have tried to solve their debt/growth trap by ramping up the central bank printing of money, in an attempt to monetize the debt, as well as erode it, as the money printing would devalue the currency that the debts were held in. However, without control of their own currency, these indebted states could not use monetary inflation to monetize and erode their debt. Sure, the ECB could print and funnel money to them covertly through the banking system, but when the problem continues to fester, the governments and banks become mired in debt.  Instead of defaulting on loans, these countries have been temporarily rescued from the brink via bailouts. The  mechanism cobbled together to help with the indebted periphery has been the bailout funds, and more recently, the ECB under pressure to become a buyer of last resort. Combined, the Bailout Funds and ECB might be enough to shore up the floor of the Euro at around 1.20, at least for the time being. In the meantime, the indebted countries might have to suffer a deep and prolonged depression to drive down wages and prices to a point where its workers and companies could generate a trade surplus to service the deficit. Otherwise, they will have to eventually default or exit the Euro.

Central Bank Intervention

Once upon a time, there was a notion that the European Central Bank’s primary mandate was to ensure price stability. Pushed into the foreground is ECB’s money printing interventions, namely the new willingness of the ECB to  print money in order to buy up the securities of troubled banks and the bonds of troubled governments.

Forbidden in its charter to print and loan money to troubled governments directly, the ECB did print and loan money indirectly to the troubled governments via the banking sector; the ECB printed and loaned money to the banking system at a low 1% for them to invest in the bonds of their own governments at a much higher percentage. This enabled the indebted governments to stumble along for a while, but eventually the sovereign debt crisis became a banking crisis, as the banks found themselves on the hook for loans given out to troubled governments on the verge of default, at the same time they were on the hook for cheap loans given out for the real estate bubble (now become “toxic assets” because the housing bubble is still falling).

In terms of Balance Sheet, the total assets/liabilities of the Eurosystem have predictably proceeded ever higher since its establishment. ECB assets have expanded in favor of ‘Loans to Monetary Financial Institutions’ (MFI) (red), code for Banks, which amounts to much of the toxic real estate assets, the quality of which has deteriorated significantly.

Now that the ECB is free to print and loan money directly to troubled governments, it will be interesting to see at what rate the balance sheet will accumulate government bonds. Will Europeans be able to stomach the painful reforms needed to return to sustainable growth, or will many Europeans wonder why they should ensure the harsh reality of economic recovery when they can simply print more money?

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Fundamentals of Euro

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